Checking the Quality of CVS' Earnings, Cash Flow

A drumroll, please: When we recently visited CVS (CVS), the drug-store chain had surprised Wall Street by unexpectedly adding an extra week to its fourth quarter. Analysts responded by boosting their fourth-quarter forecasts by a penny to 44 cents per share.

Which brings us to yesterday, when CVS, the country's second-largest (in revenue) drug-store chain, surprised Wall Street with earnings of 46 cents. Wall Street responded by bidding up CVS nearly 10% to 40.

But that did little to impress short-sellers, whose analyses of the numbers went something like this: "They engineered an earnings rise out of a disappointment," said one CVS bear. (In other words, this is another story where earnings quality wasn't as good as earnings quantity.)

First, the tax rate was lower. Second, there was the added week, when Y2K-related prescription sales zoomed in the final days of the year. Third (and this is stuff for accountants, so bear with me), the week was a bonus for revenue, but depreciation and amortization are calculated on a quarterly basis, not a weekly basis. So the quarter didn't really include an extra week of depreciation and amortization. (The less depreciation and amortization, the higher the earnings per share.)

What's more, "The number everybody looks at anyway with CVS is EBITDA," or earnings before interest, taxes, depreciation and amortization, says this bear. That's because CVS has done a lot of acquisitions. While EBITDA was up around 22%, CVS' previously rising EBITDA margin -- a sign of profitability -- was down for the second straight quarter. Could that be because CVS' auditors are getting tougher about the use of takeover and restructuring-related reserves? (CVS officials declined comment on this and anything else in this column.)

CVS has also been knocked in the past for having weak operating cash flow. (You need cash from operations to grow.) No problem: CVS bragged that its free cash flow (cash flow from operations minus capital expenditures and before dividends) jumped to $165 million for the year. Ah, but $125 million of that came from deferred income taxes. How would cash flow have been if the tax deferral was more like the $80 million deferred a year earlier? (You've heard of quality of earnings, welcome to quality of cash.) Why did the deferral rise?

Also helping cash flow: CVS is holding the line on capital spending at less than $500 million. (Walgreen (WAG), by contrast, has been raising capital spending every year and this year expects the number to top $1 billion.) "There are two sides to how much cash you're generating," says the CVS bear. "It's how much cash you're generating and how much cash you're spending. If they're doing so great, why is their capital spending going down?"

Good question, and if company officials ever decide to answer, I'll pass their comments along.

Herb's Latest: Join the discussion on TSC Message Boards .

Lernahooligan alert -- pulling out all stops: That, it turns out, is what Lernout & Hauspie (LHSP) was doing Monday when it dug (once again!) into its bag-o-tricks to juice its stock. I had pointed out the stock was up on "no news" because, quite frankly, I hadn't thought that the latest in a string of press releases justified the rise. But based on my email, not only was it responsible for the rise, but it was yet another reason why I'm an idiot. (Duh, we already knew that!)

Seriously, folks, I didn't take the press release seriously because it was yacking about a "prototype" for a Palm Pilot-like device that recognizes voice. (Lernout makes voice-recognition software.) Prototypes come a dime a dozen in Silicon Valley, where they're unaffectionately known as "vaporware" until they are actually rolled out for sale. So many prototypes simply never make it to market, and when they do, they're often produced much later than originally expected. Lernout expects its product to be rolled out "sometime" by the end of this year.

However, Lernout has more than once shown up at investment conferences armed with demonstrations of its software, only to have the demo flop. (I've only heard the stories from on-the-scene sources, not seen them.) So, armed with the new prototype of its palm device, Lernout went on CNNfn Monday night to showcase the product.

Turns out it was a fake demonstration.

According to the transcript, the Lernout device displayed this message: "Can you meet us for lunch ... on Thursday? We'll only be an hour. Whatever happened to the two-martini lunch? Got to run, Allan."

The reporter was then prompted by the Lernout exec to reply to the message. She said, "OK, why don't we say, 'No, I can't make it Thursday, but what about next Monday?'"

To which the device responded: "What are my stocks doing here?"

Huh? That has nothing to do with lunch. What happened? According to a Lernout spokesman, "It's a prototype, not a real product."

My point, precisely.

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